Tax Shield Education Centre MAFA-50
CAPITAL BUDGETING
CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process which may be divided into the following phases :
· Identification of potential investment opportunities
· Assembling of proposed investments
· Decision making
· Preparation of capital budget and appropriations
· Implementation
· Performance review
Identification of Potential Investment Opportunities
The capital budgeting process begins with the identification of potential investment opportunities. Typically, the planning body (it may be an individual or a committee organised formally or information) develops estimates of future sales which serve as the basis for setting production targets. This information, in helpful in identifying required investments in plant and equipment.
For imaginative identification of investment ideas it is helpful to (i) monitor external environment regularly to scout investment opportunities, (ii) formulate a well defined corporate strategy based on a thorough analysis of strengths, weakness, opportunities, and threats, (iii) share corporate strategy and perspectives with persons who are involved in the process of capital budgeting, and 9iv) motivate employees to make suggestions.
Assembling of Investment Proposals
Investment proposals identified by the production department and other departments are usually submitted in a standardised capital investment proposal form. Generally, most of the proposals, before they reach the capital budgeting committee or some body which assembles them, are routed through several persons. The purpose of routing a proposal through several persons is primarily to ensure that the proposal is viewed from different angles. It also helps in creating a climate for bringing about co-ordination of interrelated activities.
Investment proposals are usually classified into various categories for facilitating decision-making, budgeting, and control. An illustrative classification is given below.
1. Replacement investments
2. Expansion investments
3. New product investments
4. Obligatory and welfare investments
Decision Making
A system of rupee gateways usually characterises capital investment decision making . Under this system, executives are vested with the power to okay investment proposals up to certain limits. For example, in one company the plant superintendent can okay investment outlays up to Rs.200,000, the works manager up to Rs.500,000, and the managing director up to Rs.2,000,000. Investment requiring higher outlays need the approval of the board of directors.
Preparation of Capital Budget and Appropriations
Projects involving smaller outlays and which can be decided by executives at lower levels are often covered by a blanket appropriation for expeditious action. Projects involving larger outlays are included in the capital budget after necessary approvals. Before undertaking such projects an appropriation order is usually required. The purpose of this check is mainly to ensure that the funds position of the firm is satisfactory at the time of implementation. Further, it provides an opportunity to review the project at the time of implementation.
Implementation
Translating an investment proposal into a concrete project is a complex, time-consuming, and risk-fraught task. Delays in implementation, which are common, can lead to substantial cost-overruns. For expeditious implementation at a reasonable cost, the following are helpful.
1. Adequate formulation of projects
The major reason for delay is inadequate formulation of projects. Put differently, if necessary homework in terms of preliminary studies and comprehensive and detailed formulation of the project is not done, many surprises and shocks are likely to spring on the way. Hence the need for adequate formulation of the project cannot be over-emphasised.
2. Use of the principle of responsibility accounting
Assigning specific responsibilities to project managers for completing the project within the defined time-frame and cost limits is helpful for expeditious execution and cost control.
3. Use of network techniques
For project planning and control several network techniques like PERT (Programme Evaluation Review Technique) and CPM (Critical path Method) are available. With the help of these techniques, monitoring becomes easier.
Performance Review
Performance review, or post-completion audit, is a feedback device. It is a means for comparing actual performance with projected performance. It may be conducted, most appropriately, when the operations of the project have stabilised. It is useful in several ways : (i) it throws light on how realistic were the assumptions underlying the project; (ii) it provides a documented log of experience that is highly valuable for decision-making; (iii) it helps in uncovering judgmental biases; and 9iv) it induces a desired caution project sponsors.
Some Important Conceptions
Cash Flow – Movement of cash during the project period. Cash flows are of two types
1. Cash outflow (a) Capital nature
(b) Revenue nature.
In general discussion, investment in fixed asset and working capital are known as cash outflow. Investment on a project is not a matter of one day. However for simplicity purpose, it is assumed that the total investment is made at the starting of the project i.e. the day when commercial production starts. Cash outflow of revenue nature are adjusted with the revenue cash inflows.
2. Cash inflow = Profit After Tax ( PAT) + Depreciation.
Calculation of cash inflow Rs.
PBDT ´
less: Depreciation ´
PBT ´
less: Tax @ -- % ´
PAT ´
Add: Depreciation ´
Cash Inflow ´
NOTE :: Depreciation is a non-cash item. Depreciation is a deduction from profit, it will save certain amount of cash outflow through savings of tax. This savings in tax payment is denoted as “tax shield”. If there is no tax rate given in the problem do not charge depreciation in the calculation of cash Inflow, rather Cash-Inflow = PBDT.
3. Cash inflow at the end of the project :
(i) Working capital will be recovered in full (unless otherwise stated in the problem) and hence it is cash inflow at the end of the project.
(ii) Sale of machinery at the end of the project
(a) If the asset is fully depreciated, then sales value is the cash inflow or scrap value is the cash inflow. But if the sale value is more than the scrap value or book value, then there will be profit of short term mature and tax will be paid on that item.
Therefore cash in flow = sale proceeds – tax on profit.
(b) If the asset is sold in an earlier year & sale proceed is less than book value, then the difference will be treated as loss on sale of asset.
This loss can be set off against business income (from same or different project of the company) to produce tax shield i.e. cash inflow in terms of opportunity gain.
(iii) Selling of the old asset at the beginning of the project:
(a) If block of asset concept is not applied then pay tax on profit or losses in 1st year , But only sale proceeds of old assets is the cash inflow of the 0th year and utilised for the purpose of reducing the cash outflow in the 0th year. Tax on the profit is paid in the next year.
(b) If block of assets concept is applied –
Depreciation is calculated on remaining value of assets
No tax will be paid on profit or loss of on sale of fixed assets. However, the effect of such will be realised through difference in depreciation from coming years.
4. Choice of cut-off rates & Discounted cash - flow :
Cost of rate given Cut off not given
Loan investment No cash outflow Cash outflow in 0th
In 0th year year as interest
Rate = cut off rate.
Interest on loan is a part of PBT is not a part of PBT i.e.
i.e. PBT = PBIT – I PBT i.e. PBIT = PBT
Loan repayment Cash out-flow at the is not considered
Year of payment Cash outflow.
5. Working Capital (WC) : Investment in WC is cash outflow this is generally made at the beginning of the project . If subsequent increase in WC is required during the project life then it will be considered as cash outflow of the year of impact. We know,
WC = Stock + Debtors + Cash + Bank – Sundry Creditors
If the change in element of WC are specifically mentioned in the problems then corresponding cash inflow and outflow following their changes are to be noted for the purpose of NPV & DCF calculations
Different techniques
The Capital Budgeting techniques are :
1. When Cash flows are certain
A. Traditional Approach.
B. Time Value of Money Approach (TVM) or Discounted cash Flow Technique ( DCF ).
2. When Cash flows are un-certain :
A. GENERAL TECHNIQUE
B. Quantitatives Techniques .
1(A). Traditional Approach :
(1) Pay Back Period Method
(a) When cash inflows are uniform throughout the project life-
Pay Back Period = Original Investment ¸ Cash Inflow p.a.
Lower the Pay Back period higher the acceptability.
(b) When cash Inflows are not uniform through out the project life:
Apply the method of simple interpolation for pay back period calculation .
REQUIRED TIME - LOWER LIMIT = REQUIRED INVESTMENT - LOWER LIMIT
UPPER LIMIT - LOWER LIMIT UPPER LIMIT - LOWER LIMIT
(2) Average rate of return ( ARR): ARR = Average PAT ¸ Average Investment
NOTE : Sometimes , ARR = Average PAT / INVESTMENT
(3) Debt service coverage ratio (DSCR) = å ( PAT + DEPRECIATION + INTEREST )
DEBT REPAID + INTEREST on debt repaid
(4) Pay Back reciprocal : amount of cash in-flow after the investment is over.
(B) DISCOUNTED CASH FLOW TECHNIQUE :
1. NET PRESENT VALUE METHOD ( NPV )
2. INTERNAL RATE OF RETURN ( IRR )
3. PROFITABILITY INDEX ( PI )
4. TERMINAL VALUE METHOD ( TVM )
5. DISCOUNTED PAY BACK
6. DISCOUNTED PAY BACK PROFITABILITY
DERIVATIONA OF ANNUITY FORMULA
Future value of an annuity : A (1 + k)n – 1
k
Present value of an annuity : A (1 + k)n – 1
k (1 + k)n
Present value of a perpetuity : A .
k
The derivations of these formulae are discussed below.
Future Value of an Annuity
The future value of an annuity is :
FVn = A(1 + k)n-1 + A(1 + k)n-2 + … + A(1 + k) + A
Multiplying both the sides of Eq. (4A.1) by (1 + k) gives :
FVAn (1 + k) = A(1 + k)n + A(1 + k)n-1 + … + A(1 + k)2 + A(1 + k)
Subtracting Eq. (4A.1) from Eq. (4A.2) yields :
FVAn k = A [(1 + k)n – 1 ]
Dividing both the sides of Eq. (4A.3) by k yields :
FVAn = A (1 + k)n – 1
k
Present Value of an Annuity
The present value of an annuity is :
PVAn = A(1 + k) -1 + A(1 + k)-2 + … + A(1 + k) –n
Multiplying both the sides of Eq. (4A.5) by (1 + k) gives :
PVAn (1 + k) = A + A(1 + k) –1 + … + A(1 + k) –n+1
Subtracting Eq. (4A.5) from Eq. (4A.6) yields :
PVAnk = A [1 – (1 + k) –n] = A (1 + k)n – 1
(1 + k)n
Dividing both the sides of Eq. (4A.7) by k results in :
PVAn = A (1 + k)n – 1
k(1 + k)n
Present Value of a perpetuity
A perpetuity is an annuity of an infinite duration. Hence the present value of a perpetuity is expressed as :
PVA = A(1 + k) –1 + A(1 + k) –2 + … + A(1 + k) -+1 + A(1 + k) -
Multiplying both the sides of Eq. (4A.9) by (1 + k) gives :
PVA (1 + k) = A + A(1 + k) –1 + … + A(1 + k) -+1
Subtracting Eq. (4A.9) from Eq. (4A.10) yields :
PVAk = A [ 1 – (1 + k) - ]
As (1 + k) - à 0, Eq. (4A.1) becomes :
PVAk = A
This means :
PVA = A .
K
Equation (4A.13) implies that the present value of a perpetuity of Re.1 is simply : 1 .
k
CONTINUOUS COMPOUNDING AND DISCOUNTING
Continuous Compounding
In Chapter 4, the following relationship was established for a case where compounding occurred m times a year.
r = 1 + k . m - 1
m
where r = effective rate of interest
k = nominal rate of interest
m = frequency with which compounding is done in a year
Equation may be expressed as
r = 1 + k . m/k k - 1
m/k
Putting x = m/k in Eq. (4B.2), we get
r = 1 + 1 . x k - 1
x
In continuous compounding m à . This means x à in Eq.
Lim 1 + 1 . x = e = 2.71828…
X à x
So from Eq. we get
r = ek – 1
This leads to
(1 + r) = ek
Thus, the equation for future value, when continuous compounding is done, is a follows :
FVn = PV x ekn
To illustrate, the future value of Rs.50,000 deposited today for 5 years at 8 percent, compounded continuously, is equal to :
FV5 = Rs.50,000 (2.71828) .08x5
= Rs.50,000 (1.49182)
= Rs.74,591
Continuous Discounting
Employing the about reasoning the present value of a future sum, when continuous discounting is done, is given by the following formula :
PV = FVn x e –kn
where PV = present value of a future sum
FVn = future sum at the end of n years
k = nominal discount rate
To illustrate, the present value of a future sum of Rs.50,000 receivable after 7 years, when discounting is done at 12 percent on a continuous basis, is equal to